The Wheels of the ‘Great Rotation’ Turn Slowly

The argument that stocks will rally as bonds fade might be true, but isn’t quite so cut-and-dry — as the Fed minutes show investors

Well, a month or so ago, the hype about a “Great Rotation” from bonds into stocks reached a fever pitch. But don’t hold your breath.

The theory in a nutshell is that as the Fed tightens policy over the next few years, investors holding bonds from the ZIRP era will flee their positions. That will result in a flow of cash to newer interest-bearing assets, but also into stocks since an uptick in rates likely would be contingent on significant economic stability.

Many investors are eager for this shift to happen, and bullish about the next few years as a result. But it’s very risky to filter all of the recent news through the perspective of the Great Rotation — because you’ll wind up seeing what you want to see, and miss the true facts.

And the fact is that any rotation is going to happen slowly, and will take years to achieve.

This is a hard reality that many bulls don’t want to admit. Just last week, a top executive at Amundi Asset Management — a firm with $1 trillion under its roof — predicted the rotation has begun and told the Wall Street Journal that equities will outperform in the next 12 to 18 months as investors go “risk on.”

But remember a simple truth about capital markets: There always is a counterparty, and without a magic wand, you cannot convert all the money in one asset class to investment in another. Coca-Cola (NYSE:KO) doesn’t issue new stock just because it’s a bull market, and bonds don’t get retired early just because investors rotate out.

Or put plainly: Lots of people also will be buying bonds and selling stocks for this Great Rotation to happen. That will subsequently affect pricing, and in turn the pace and volume of these sales.

Enough with abstractions. Let’s get to the meat here:

Investors have been rushing into stocks lately, but inflows have cooled off significantly since the beginning of the year. Check this graphic from Hibah Yousuf of The Buzz blog at CNNMoney, which shows the pace of inflow to stock mutual funds from bond funds has “slowed considerably” since the beginning of 2013. In fact, we are cruising back to flat — perhaps even into outflow territory.

Furthermore, as Marc Chandler of Brown Brothers Harriman points out, “There is a third asset class that needs to be integrated into the analysis: cash.” He goes on to state that one analysis showed “cash holdings rising by about $350 bln in the Nov-Dec period and about $165 bln has flowed out since the start of the year.”

A Great Rotation might well be under way. But it’s not as simple as just flipping a switch. There will be many periods where stocks will look too expensive for new money — as they have in the last week. There also will be periods where cash or cheap bonds will remain in favor.

So if you’re looking for a megashift in the market this year, you might be out of luck. A rotation from bonds to stocks — or among any asset classes including commodities or even cash — naturally takes time and sees momentum wax and wane.

But use that to your advantage. Because the bottom line is the stock market will come back and the bond market will see big upheaval when the Federal Reserve eventually raises rates. The periods when stocks cool off, as we are seeing right now, could be a good time to enter and avoid the feeding frenzy when everyone is buying.

At a Glance

A Great Rotation might well be under way. But it’s not as simple as just flipping a switch. There will be many periods where stocks will look too expensive for new money -- as they have in the last week. There also will be periods where cash or cheap bonds will remain in favor.